Although people drive the business of doing business, money fuels the engine. That money can be counted, compiled, and presented in numerous ways — ways that, in the right hands, can provide a steady flow of financial information with which you can accomplish a number of key business functions, including the following:
- Maintaining bookkeeping information: The bookkeeping process includes keeping records of physical inventories, monies due from others (accounts receivable), and monies due to others (payroll and accounts payable).
- Paying taxes: Federal, state, and local governments require not only that every business pays taxes but also that it keeps records to back those payments.
- Keeping score: In order to determine whether you’ll be able to meet next month’s expenses or whether your business’s profitability and cash are trending in the right direction, you need to keep track of the results of doing business.
- Providing a management information tool: Information fuels the decision-making process, and the more information you have as a small-business owner, the better your decisions will be.
This article is about collecting and using financial information to best manage your business. Fortunately, you don’t have to be a financial expert or whiz to understand the numbers. (Do you have to understand how a thermometer works to take your temperature?)
After a thorough review of this article, some time spent with your tax advisor, and several months of closely reviewing your personal financial statements, you’ll be able to properly use the financial information your business’s accounting system generates.
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Manage and Track Small Business Cashflow
To pay your bills, you need to manage the money/cash you have going out and coming in — that is, your cash flow. Before you can have cash flowing out, you must have cash flowing in. When your cash flows out in excess of what flows in, your business is heading for trouble.
To understand the basic concept of cash flow, you first need to distinguish between the following two oft-confused terms:
- Cash flow: An operating term that describes the movement of money (cash, checks, electronic debits, and credits) in and out of your business.
- Profitability: An accounting term that refers to the capability of your business to generate more sales dollars than what it costs to run your business.
When a business is profitable, profits don’t necessarily accumulate in the form of cash. Instead, they can take the form of an increase in other noncash assets, such as inventory, accounts receivable, equipment, or real estate. Yes, those profits may once have been in the form of cash, but somewhere along the line, you may make the decision to shift that cash into another asset — purchasing additional inventory or buying a piece of equipment, for example. In this manner, your business can be profitable in accounting terms but still be short of cash in the checkbook.
Although an increase in cash is only one of the many possible results of profitability, it is, by far, the most important result because cash fuels the day-to-day operation of your business. If you’ve chosen to spend too much cash on purchasing inventory and equipment or if you’ve been slow in collecting your accounts receivable, you may not have enough cash to pay your vendors and compensate your employees. After all, you can’t pay them with inventory or equipment!
Ironically, some profitable (in accounting terms) businesses have entered bankruptcy because their owners made the wrong choices when allocating the business’s precious cash. Instead of accumulating it, they (knowingly or unknowingly) spent it on nonliquid assets, and then, lo and behold, the bills came due and the cupboards were bare.
Your business’s bank account (or money market fund) is the obvious measure of today’s cash. Do you have enough money in it to pay today’s bills and meet today’s payroll, and will you still have money left over when the day is done?
The difficulty comes in projecting how much cash you’ll need in the future. Because every business must be concerned with more than just what’s happening today in terms of cash availability, projecting tomorrow’s cash flow is an important task. To do that, you need to consider questions like the following:
- Will you have enough cash to meet next Friday’s payroll?
- Will you have enough cash to pay that big vendor invoice that’s due the following Monday?
- Will you have enough cash to pay the bank-loan payment, the upcoming utility bills, and the real estate taxes that will be due at the end of the month?
Questions like these, and the answers they beg, point out the need for preparing cash flow projections — forecasts of how much cash you’ll have over a given future time frame. Some businesses project cash flow for 30 days out, some for six months, and some for an entire year in advance. To project cash flow accurately, you need to polish up the old crystal ball because you’re about to make many important predictions. For example, you must predict
- Your future sales
- The rate at which you’ll collect the money that’s due you from those sales
- The dollar amount of your upcoming payrolls
- The dollar amount of vendor invoices to be paid in the next day, week, month, six months, or even year
The better your predictions, the more accurate a forecast you can prepare.
You can prepare your cash flow projections for the next day, next week, next month, next year, or any combination thereof. Predictions for longer time periods, although potentially useful, are likely to be fuzzier and less accurate than predictions for shorter time periods.
We recommend that you make your cash flow projections for at least six months out and then update them at least once each month, always staying six months out. That way, you’ll spot problem periods earlier and be able to adjust to them more quickly.
Although most small businesses don’t generate cash flow projections daily, you should be tracking cash on a monthly basis. (You say you do generate projections daily? Then you’re our hero.) After all, no matter how small or uncomplicated your business happens to be, cash is key. We can guarantee you one thing: At some point in your business career, you will have cash flow problems. Wouldn’t you rather anticipate the problem before it happens than let it blindside you?
Most accountants have a preformatted cash flow projections worksheet available for their clients to use. Whether you use their worksheet or something you create on your own, make sure you understand the concept of cash flow because it’s one of the most important (and least understood) financial concepts that a small-business owner must know.
Don’t let cash flow intimidate you. The concept is as simple as the concept behind maintaining a checkbook (for example, knowing the balance in your checking account, given the inflows and outflows that you know are coming). Cash flow is nothing more than a few new wrinkles on an old, familiar face.
Understand Your Small Business Financial Statements
Whether manual or computer-based, the accounting system you use should ultimately generate two financial statements: the profit and loss statement (also known as the income statement) and the balance sheet. Both of these statements are produced at the end of a business’s accounting period, usually monthly, quarterly, or annually.
We recommend that you prepare (or have prepared) your financial statements as frequently as possible, with monthly statements usually being the most useful. If your accounting system allows you to generate your financial statements internally, we suggest that you generate your statements monthly. If monthly statements are impossible for some reason, quarterly statements will do, but don’t fall into the trap that many small businesses do by generating your statements only once or twice a year.
Financial statements function primarily as a management tool, and you can’t go 365 days without paying attention to the information they provide. The following sections discuss the profit and loss statement and the balance sheet.
The profit and loss statement
The profit and loss statement (P&L) adds all the revenues of your business and subtracts all the operating expenses, thereby providing you with a figure that represents what’s left over: the profits. (If the total expenses exceed the total revenues, your business would have a loss rather than a profit.) The P&L measures the results of operations of your business over a given time period — typically a month, a quarter, or a year.
Choosing a P&L format
When you sit down with your bookkeeper and/or tax advisor to design your financial statement format, always remember the cardinal rule of business numbers: Any given number is meaningful only when compared to another number.
For instance, say you’re the CEO of American Airlines and your company shows a profit of $7 billion this year. Most outsiders would see that as a positive result, but if American Airlines showed a profit of $14 billion the previous year, a 50 percent profit decline spells big trouble. And so it is with your business. You need to compare the current year’s figures to other numbers — last year’s actual performance or this year’s budget or, preferably, both.
In Figure 1, we offer a sample P&L to help you understand how to construct one and how to effectively use it in managing your business.
The process you use to arrive at a P&L’s net income conclusion isn’t difficult to understand. Just follow these two easy steps:
- Subtract from the gross sales (in Figure 1, $500,000) the cost of the goods that were included in those sales (in Figure 1, $225,000). What’s left is the gross margin on those sales — the difference between what it costs you to produce your product or service and the price you charge for it (in other words, the gross income before subtracting operating expenses). Figure 1 shows this figure to be $275,000.
- Subtract from that number all the operating expenses incurred during that accounting period — including all selling and administrative expenses. In Figure 1, $234,000 is the number you subtract. The number left over is — how easy is this? — the net income. Ta-da! Our sample company had a net income of $41,000.
As you can see, the trick is not so much in assembling the P&L but in retaining and retrieving all the figures that go into it. The better your accounting system, the easier this process will be.
Deciphering P&L information
Deciphering important information from a P&L is easy:
- Go to the net income figure under the Current Year column — the P&L number that every small-business owner is most interested in. Using the percentage in the next column, you can quickly determine how profitable Big Spenders Corporation has been this year compared to the previous year. (Profits are down by 18 percent.)
- A quick glance at the top row of the statement reveals that the profitability decrease isn’t due to falling sales, which are up by 11 percent, nor is it due to a declining gross margin, which is up by 10 percent. Because sales and gross margin are both positive, you can assume that the problem must be related to expenses.
- Moving down the expense items, you see that wages and salaries are up by 29 percent. This means that, although sales have increased by 11 percent and the gross margin is up by 10 percent, the whopping increase in wages and salaries has caused the problem. A quick comparison to the wages and salaries budget reveals that the 29 percent increase wasn’t budgeted; therefore, whatever has happened wasn’t planned for. You can then delve into your wages and salaries account to determine what caused the problem.
Some companies may include an additional three columns on the P&L. These three columns represent the percentage of the total for the Prior Year, Budget, and Current Year categories. For example, using the sales total as 100 percent, every figure in each column would represent a percentage of that total.
Thus, continuing with the Big Spenders Corporation example from Figure 1, the percentage of the total for the Current Year column would reveal a gross margin to sales of 55 percent ($275,000 divided by $500,000), wages and salaries to sales of 19 percent ($97,000 divided by $500,000), and net income to sales of 8.2 percent ($41,000 divided by $500,000). The only disadvantage of adding these three columns is that it clutters up the P&L and makes it more difficult to read.
After you have your P&L prepared in an easy-to-read, four-column format, you can relatively easily determine what your business has done and where it currently needs to improve. In other words, you’ll know your trend.
For example, by comparing the columns, the P&L allows you to quickly answer the three questions that define any business’s profitability:
- Have you controlled your costs? For Big Spenders Corporation, the answer appears to be no.
- Have you maintained or improved your gross margin? In this example, the answer is yes.
- Have you maintained or increased sales? In this example, the answer is yes.
Although the answers to these three questions provide significant help in managing your business, the answers aren’t the only information the P&L provides.
The balance sheet
The balance sheet provides a snapshot of a company’s financial position at any given point in time. As with the P&L, the concept behind a balance sheet isn’t complex. Quite simply, the balance sheet is a list of what your business owns (assets) minus what your business owes (liabilities), with the resulting difference being what your business is worth (net worth). This net worth figure is also commonly referred to as book value.
The P&L is designed to analyze profitability issues: sales, margins, and expenses. The purpose of the balance sheet, on the other hand, is to analyze an entirely different issue: resource (dollar) allocation. Did you decide to allocate your dollars to increasing inventory, to paying off loans, or to accumulating cash? The small-business owner makes many asset-allocation decisions over the course of the year; the balance sheet provides a year-end snapshot that summarizes the history of those decisions.
In Figure 2, we provide a sample balance sheet to help you understand how this important financial statement works.
We’ve prepared the balance sheet in Figure 2 in the same four-column format that we use in the P&L (refer to Figure 1). This format is designed to simplify the comparison of the prior year, budget, and current year figures. Although we suggest that you consider this format when preparing your own balance sheet, we should note that most businesses don’t budget their balance sheets but still operate successfully.
In the example in Figure 2, Big Spenders Corporation completed the current year with an increase in net worth of $34,000 ($125,000 to $159,000) over the prior year. By comparing the Current Year column on the balance sheet with the Prior Year column, you can readily determine what has happened to the mixture of assets and liabilities over the year — in other words, how Big Spenders Corporation’s management decided to allocate the company’s resources.
To give you another example of how easy it is to glean information from this four-column balance sheet format, look at the Percent Change Compared to Prior Year column. Note that although the total current assets didn’t change appreciably, two of the categories within the Current Assets category — cash and inventory — did. The cash account, as of December 31, is only $5,000, while inventory has ballooned to $85,000. Sometime during the current year, a larger inventory has built up, depleting the company’s cash reserves in the process.
An examination of the Budget column confirms the fact that this inventory accumulation was unplanned and unbudgeted. (Incidentally, this is a perfect example of how a company can be profitable and still get into financial trouble.) As evidenced by the balance sheet, Big Spenders Corporation currently has $90,000 in short-term liabilities but only $5,000 available in cash. As a result, despite being profitable, Big Spenders is in a classic cash crunch.
The only other percentage on this sample balance sheet that should attract immediate attention is the 55 percent decrease in long-term notes payable. Sometime during the year, management decided to pay off a portion of its long-term debt — a decision that, in light of the company’s present cash shortage, they would now probably like to reverse.
The Small Business Accounting Ratios You Must Know
Before you can take the numbers generated by the P&L and balance sheet and turn them into meaningful management tools, you need to consider two overall points about the numbers, ratios, and percentages that come from those financial statements:
- Comparisons work best. Your company may have what appears to be a respectable percentage of net profit on its sales, but if that percentage is less than it was during the same period the preceding year, trouble may lie ahead. Numbers are most effective when you can use them to identify trends — and identifying trends always requires a comparison of numbers over time.
- The industry matters. Acceptable numbers in one industry may not be acceptable in another. Industries vary widely in the numbers they generate. For example, if you’re in the software business, you may be disappointed with a 15 percent profit return on your sales dollar (we explain what that means in the next section). If you’re in the grocery store business, however, you’d probably be ecstatic with a 5 percent profit return on sales.
If you don’t know the acceptable ratios and percentages in your industry, contact your appropriate trade association. Most trade associations can give you the benchmark ratios and percentages that you need to know to compare your own business to industry averages. Check out the Small Business Sourcebook (Gale) to find a list of the trade associations applicable to your profession or search for them online.
We strongly suggest that you learn how to extract the key ratios and percentages from your financial statements by yourself instead of depending on your bookkeeper or tax advisor to do so.
The process itself gives you a better idea of where the numbers come from and how you can use the financial statements for other ratios and percentages that may be meaningful to your individual business. Although any ratio or percentage alone won’t give you all the information you need to become a sophisticated financial manager, the knowledge of how they all work together will make you much more effective as an owner/manager.
In the following sections, we explain the most common percentages and ratios that a small-business owner should understand.
Return on sales (ROS)
Return on sales (ROS) is a percentage determined by dividing net pretax profits (from the P&L) by total sales (also from the P&L). The resulting figure measures your company’s overall efficiency in converting a sales dollar into a profit dollar. ROS very much depends on what type of business you operate.
ROS is an excellent figure on which you and your employees can focus. It’s relatively easy to track, understand, and explain. Some businesses use this percentage as a company-wide scorecard to help their employees understand how the businesses make money, thus motivating them to do their part in assuring and improving profitability. (Most employees think their businesses make much, much more money than they really do.)
Return on equity (ROE)
Return on equity (ROE) is a percentage determined by dividing pretax profits (from the P&L) by equity/net worth (from the balance sheet). The resulting figure represents the return you’ve made on the equity dollars that are effectively invested in your business.
Over several years, if your return on equity isn’t higher than 5 percent or thereabouts (which is the average return on money invested in such secure investments as short-term, high-quality bonds), you may want to consider selling your business and investing the proceeds in bonds. Your return would be similar, but your risk and the work involved would be much less.
This assumes, of course, that you’re in business to make money. If, however, you’re motivated by something else — creativity, growth, independence — or if you simply like owning your own business, you may be content with miniscule earnings, even though you can make a similar or better financial return elsewhere.
Note: Both ROS and ROE are impacted heavily by the amount of money the owner decides to take out of the business in the form of salaries, bonuses, and benefits. Obviously, the more taken out, the lower the ROS and ROE percentages will be.
Gross margin is a percentage determined by subtracting your cost of goods sold (from the P&L) from total sales (also from the P&L). This figure represents your business’s effective overall markup on products sold before deducting your manufacturing and/or service-providing expenses.
How high or low your gross margin is depends on your industry, your business, your pricing strategy, and the products or services you’re selling. The trade association for your industry can give you industry-wide benchmark numbers for gross margin.
Trend is especially important with gross margin. Over time, you want to see an increasing rather than decreasing gross margin.
Current ratio is a ratio determined by dividing current assets (from the balance sheet) by current liabilities (also from the balance sheet). The resulting figure measures your business’s liquidity (the ability to raise immediate cash from the sale of your assets); thus, this ratio is of great interest, especially to your lenders and/or outside investors.
The higher the current ratio, the more liquid your business. Generally, current ratios in excess of 2 to 1 are considered very healthy; anything less than 1 to 1 is in the danger zone. Again, trend is especially important here. Over time, you want to see an increasing rather than decreasing current ratio.
The debt-to-equity ratio is a ratio determined by dividing equity/net worth (from the balance sheet) by debt/total liabilities (also from the balance sheet). The resulting ratio indicates, in effect, how much of the business is owned by the owners (represented by equity/net worth) and how much is owned by its creditors (represented by debt/total liabilities).
Generally, a 1-to-1 ratio is considered healthy; anything less is questionable. To further illustrate this point, refer to the Big Spenders Corporation balance sheet in Figure 2. Note that Big Spenders owes its creditors and debtors $175,000 (its total liabilities), while the company’s net worth is $159,000 (the owners’ equity).
This means that as of the date that this balance sheet was assembled, Big Spenders Corporation’s creditors and debtors had $16,000 more working for the company than the owners did (the difference between $175,000 and $159,000); therefore, its debt-to-equity ratio exceeds 1.0 or 100 percent. If the owners needed another loan to make ends meet, they’d have a hard time showing that their financial stake in the company justified another loan.
Keeping the debt-to-equity ratio within the healthy 1-to-1 parameter is of paramount importance. For example, when the debt-to-equity ratio exceeds 1.0 or 100 percent, such cash-draining options as adding inventory, hiring new employees, and buying new equipment should be put on hold until the ratio becomes more lender friendly.
Inventory turn is the number of times your inventory turns over in a year. You determine the number by dividing your total cost of goods sold for the year (from the P&L) by your average inventory (beginning inventory + ending inventory ÷ 2).
For example, if your beginning inventory (on January 1) was $100,000 and your ending inventory (on December 31) was $150,000, your average inventory would be $125,000. Your inventory turn shows how well you’re managing your inventory. The higher the number, the more times your inventory has turned, which is always preferable.
The number of times your inventory turns is highly dependent on your industry (manufacturer, wholesaler, or retailer) and your role in it. Typical inventory turns can range anywhere from 5 to 20 times a year. Consult your trade association for inventory turn ratios that apply to your industry.
Number of days in receivables
You determine the number of days in receivables — that is, the average length of time between selling a product or service and getting paid for it — by first computing your average sales day. Divide your total sales for the period (from the P&L) by the number of days in that period (for a year, use 365). Then divide your average sales day into your current accounts receivable balance (from the balance sheet). The resulting figure gives you the number of days in your receivables.
Generally speaking, fewer than 30 days in receivables is considered excellent, between 30 and 45 days is acceptable, and more than 45 is cause for concern.
EBITDA is an acronym that stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. EBITDA is computed by adding back interest, taxes, depreciation, and amortization to net income. Those four expenses are non-operating expenses, so after adding them back you have a number that represents the pure operating results of your business. The EBITDA number is always used in transactions that relate to buying and selling a business — in other words, valuing a business.
Inventory Management For Your Small Business
The opportunities to improve profitability through the efficient handling of inventory are endless. Inventory isn’t gray, like marketing, or in the future, like sales; it’s here today and resting on your shelves, available to touch, feel, and count. As a result, if you improve your efficiency in handling inventory, your business can have a double financial benefit:
- Profitability: The less inventory you have to write off, the more profitable you become.
- Cash flow: The fewer dollars you have tied up in inventory, the more cash you have in your bank account.
Aside from texting while driving, accumulating excess inventory is the quickest and easiest way we know of to get into trouble. Excess inventory and its long list of hidden horrors have turned many a healthy small business into an ailing one.
Unlike getting rid of employees who aren’t performing, you can’t give inventory that isn’t performing a pink slip and send it out the door. Nor can you step up your collection effort with your inventory, as you can with slow-moving receivables. Nonperforming inventory just sits there, collecting dust, and generally depreciates.
If the inventory is an integral part of your small business, use the following tips to manage it effectively:
Gather information on past purchasing and sales transactions. Preventing inventory accumulation starts with the person doing the purchasing. The more information on past purchasing and sales transactions that person has, the better his future purchasing decisions can be.
Divide your inventory into small, manageable pieces. Pay especially close attention to those pieces where you have the most financial exposure. Remember, inventory is subject to the 80-20 rule: You usually get about 80 percent of your sales from 20 percent of your inventory units. Pay special attention to closely tracking that 20 percent.
Make sure that you have a workable system and qualified employees in place at the inventory-handling corners: shipping and receiving. Most inventory disappearance problems can be identified at one of these two positions. If your inventory system is manual, ask an experienced tax practitioner to help you establish a workable digital or electronic system.
Take frequent physical inventories. To determine whether you’re having inventory-shrinkage problems and, if so, how significant they are, count the items in your inventory and compare your physical count to your financial records. (If you divide your inventory into small, manageable pieces, you can more readily determine where the shrinkage is occurring.) Taking a physical inventory is the only way to ensure that the gross margin figures on your P&L are correct. We suggest that most businesses take a thorough physical inventory at least twice a year and preferably four or even six times.
When selecting suppliers, don’t simply settle on the supplier with the lowest price. Include delivery time and shipping dependability at or near the top of your criteria. After all, the shorter the delivery time and the more dependable the vendor, the less of that vendor’s inventory you’ll have to carry. Some vendors allow returns on inventory you’ve purchased from them, often charging a restocking fee of some sort. In most cases, a vendor’s willingness to take back items that don’t sell is an added benefit, assuming that the restocking fee isn’t too high.
Collect Accounts Receivable for Small Businesses
Banks aren’t the only institutions in the business of lending money; most small businesses lend money, too. The primary difference between the two, however, is that when banks lend money (known as loans) to their customers, they charge interest; when small businesses lend money (via accounts receivable) to their customers, they usually don’t charge interest.
Think about it: When customers buy your product (unless your business deals only in cash), you usually give them 30 days to pay the invoice. During those 30 days, the customer not only has your product but also, in effect, has the cash that’s due you — the same cash that you can otherwise use to reduce your debt, pay your bills, or invest to your benefit.
Today’s business culture places the customer on a pedestal, as well it should. After all, someone has to purchase your products or services. But the word customer is incomplete; the correct phrase should be paying customer. Today’s successful entrepreneurs know that a customer isn’t a desirable customer until she has paid the bill.
1. Finding paying customers
The following list presents our time-tested collection of tips on how to find and do business with paying customers:
Use a credit application. Design and use your own credit application. Ask one of your vendors if you can use its application as a sample. Make sure that every potential customer fills one out before you ship an order or provide your service. The credit application you use should include, among other things, the customer’s references (other vendors used by the customer), the name of the customer’s bank, the person responsible for accounts payable, and the name of the owner/president/CEO (the person ultimately responsible for the customer’s debts). And be sure to check the references provided in the application.
Evaluate every applicant. Ask yourself these questions about every prospective customer who submits a credit application, and if the answer to any of these questions is no, feel free to wave goodbye to the prospective sale.
Ask for a financial statement. Don’t be afraid to ask for a financial statement before shipping to a first-time customer. Can you imagine a bank lending you money for your business without first asking you for a financial statement?
Check credit. You can bet that your good vendors checked your credit; you should check your customers’ credit, too. Remember that the granting of credit is a privilege; in effect, you’re lending money to the person requesting it. Grant credit the way banks do — with care.
Establish terms. No sale should be made without first establishing credit terms. Terms should work for both parties, but remember your signature on the bank’s guarantee when a customer wants you to carry his receivables for long periods of time. Your bank won’t back off its terms — why should you?
2. Manage your accounts receivable
Every successful small business needs someone dedicated to the collection of accounts receivable. In the early stages of the business, that someone is almost always the entrepreneur or founder. In later stages, that responsibility may be delegated to a bookkeeper, controller, or Chief Financial Officer (CFO). But whoever that person happens to be, he must be passionate about collecting the monies due the business.
After you’ve properly established your accounts receivable record-keeping functions, you need to figure out how to manage them. The following tips can help you do just that:
Bill promptly. Bill the same day you ship or, in the case of a service business, the same day you fulfill the customer’s order or the terms of the contract. If you wait until the end of the month to prepare and/or mail invoices, you further increase the number of days before you’ll receive the cash.
Track the time it takes your customers to pay their bills. You need to age all outstanding receivables at least once a month. (In other words, you need to compute the number of days that every receivable has been outstanding. Companies where money is tight generated aging lists every day.) Creating an aging list reminds you who’s in control of a large amount of your company’s cash. An acceptable age of a receivable (in most industries, anyway) is 30 days; danger signals should appear after a receivable exceeds 45 days.
Begin collections promptly. Don’t wait until your receivables are more than 90 days old to kick in your collection procedures. Do so while the invoice is still warm (no more than 45 days).
Utilize a carrying charge or interest charge. Why shouldn’t you charge interest on overdue balances? After all, you’re expected to pay a carrying charge to many of your vendors when you exceed your payment terms (review your credit-card agreement if you have any doubts on this one). Don’t charge anything less than 10 percent annualized. A relatively high-interest rate will ensure that you get the overdue account’s attention.
Don’t ship to nonpayers. Don’t continue to ship to customers who don’t pay in accordance with your terms.
Involve the boss. Consider picking up the phone yourself when the bill-paying stalling becomes noticeable. A call from the owner or boss may be more effective than a call from the bookkeeper.
Use a collection agency only as a last resort. Collection agencies are expensive, charging up to 50 percent of the receivable for their services. Also, collection agencies aren’t known for their consideration and politeness. Be prepared to kiss your customer goodbye forever if you choose to hand your slow-paying account over to an agency.
Your accounts receivables represent cash, and cash is the ultimate measure of your business’s liquidity. Liquidity is the first place lenders and investors look when appraising the health of a business. Make sure that your receivables are current before showing your financial statements to people who have a reason for reading them.
The Three Ways to Increase Your Business’s Profitability
Every small-business owner spends a significant amount of time trying to increase the business’s profitability — the difference between revenue (the money you take in) and expenses (the money you pay out). No one succeeds in increasing profitability all the time, no matter how hard he tries. Some succeed often enough to grow a small business into a larger one. Some succeed just often enough to survive. And, unfortunately, some don’t succeed at all.
The three ways to increase your business’s profitability are
- To decrease expenses
- To increase gross margin
- To increase sales
You can do all three at the same time — that is, if luck and the time you have to devote to the task are on your side. However, our advice would be to pick the easiest option first (decreasing expenses). Then proceed to the second easiest (increasing gross margin) and then, finally, to the toughest (increasing sales). Unfortunately, too many entrepreneurs start with the sales option first (after all, increasing sales is more fun than cutting expenses). While we applaud their gusto, they’re approaching the process from the wrong end and won’t see the same immediate results they’d get if they started with expenses.
Instead of proceeding by trial and error, you can use a thorough understanding of how these profitability-improving options work to determine exactly what to do when your profits aren’t what they should be. In the sections that follow, we explain what you need to know about each of these three options.
1. Decreasing (or controlling) expenses
The biggest advantage that comes from decreasing, or controlling, your expenses is that expense cuts generally have a direct and short-term impact on the bottom line. For every dollar you save by cutting or eliminating an expense, you earn an extra dollar of profit. (Sure, increasing sales is another way to increase profits, but an extra dollar in sales may bring in only 25 cents of profit. We explain more about that shortly.)
Of course, not all expense cutting is equal. It’s one thing to cut your expenses by changing your Internet service provider, but if that change results in slower service, does it make sense? Where lower costs involve lower quality, the result of that lower quality needs to be factored into the decision.
So although we’re strong advocates of operating a lean business, you must be thoughtful about where and how you reduce your expenses. You need to consider all the effects of cost-cutting — not just the short-term, bottom-line effects — before you make any cuts.
Controlling expenses is a cultural issue, which means that it’s a lead-by-example issue that begins with you, the business owner, and carries over to your employees.
From the day you open your business’s doors, you must pay close attention to managing its expenses, being careful not to spend money carelessly and being tactfully critical of those who do. If the boss sets the right example, the rest of the company is certain to follow. That’s how a company culture is established and flourishes.
The following sections give you guidelines for successfully controlling expenses.
After you determine what kind of expense-controlling culture you want to set up in your business (and then make the commitment to act accordingly), your next step is to introduce a zero-based budgeting program. Zero-based budgeting requires that you begin each year’s annual budget process by setting each expense category at zero. In other words, you don’t assume that the dollar amounts in the preceding year’s expense account were needed; you question every dollar that went into that expense account — hence, the term zero-based.
The zero-based budgeting approach contrasts with the way many businesses budget expenses. Most businesses add a percentage increase to the preceding year’s expenses, with the rate of the prior year’s inflation increase being the most frequently used common multiplier. If last year’s inflation rate was 3 percent, for instance, many businesses just plug in 3 percent increases to arrive at this year’s budget.
The primary advantage of budgeting by the percentage-increase method is that it’s quick and easy. The primary disadvantage is that it carries last year’s fat into this year’s menu. Ditto with next year’s menu, and so on, forever — unless that expense category is eventually thoroughly questioned through the zero-based budgeting technique.
Here’s an example of how zero-based budgeting works: Suppose it’s time to budget your telephone expense for the year. The quick-and-easy solution is to take the preceding year’s telephone expense figure, add 3 percent (or whatever inflation is), and move on to the next line item on the P&L. However, the zero-based budgeter’s job is to examine and evaluate the company’s telephone needs — to determine what kinds of calls need to be made and then to contact alternative carriers, collect quotes on their services, and award the business to a less-expensive but comparable-quality provider.
In addition to zero-based budgeting, effective control of expenses requires understanding the 80-20 rule as it applies to expenses. The 80-20 rule maintains that you can usually find 80 percent of wasted expense dollars in 20 percent of the expense categories.
As you create your budget, challenge expenses in all categories, large and small. You can usually find quick-and-easy dollars to save by rooting around in such overlooked expense categories as utilities, travel and entertainment, insurance, and the compost heap of them all, the miscellaneous category.
The following tips provide a framework in which you can effectively control your expenses:
- Avoid overstaffing. Finding and hiring a good employee is costly, and after you’ve hired one, unhiring her is not only difficult but also expensive. Use outside contractors, temporary services, and part-timers if you’re on the fence about the need to hire a full time employee.
- Automate where possible. Technology is usually cheaper than people (and it can be depreciated). When possible and when doing so won’t compromise the quality of your products or services, purchase software in lieu of hiring additional employees. Functions such as accounting, inventory control, accounts receivable, and payroll lend themselves to automation. Let technology do your detail work.
- Don’t wait until a crisis arrives to do something about your expenses. Institute an expense-control program when things are going well; you don’t have to wait until the roof caves in. Be motivated by efficiency, not by fear.
- Put the responsibility for controlling expenses where it belongs — in the hands of the employees who spend the money. Also, make them accountable for their actions. Reward them when they meet their goals and provide corrective feedback when they don’t (that’s Management 101!).
The preceding tips are intended to provide you with an overview of how to control your expenses. Following are several cost-controlling measures, intended not only to give you specific ideas but also to put you in the frame of mind for getting serious about managing your expenses:
- Ask for price quotes before you obligate yourself to services. This is true for everything from lawyers, accountants, and financial advisors to computer repair people, plumbers, and consultants. (Often the quotes won’t hold up, but they’ll give you a basis on which to negotiate subsequent charges.) Also, make sure that you always ask for itemized invoices.
- Don’t pay unnecessary bank charges. Question the fees on your statements. Shop around if your bank is charging more than competitors for services. Just about everything is negotiable, including bank charges.
- Shop your telephone service every year or so. Everyone is discounting telephone services as technology and deregulation make prices more competitive.
- If you have employees, review your experience modification factor with your insurance agent. Your experience modification factor is the tool that determines your workers’ compensation insurance payment. Speaking of insurance agents, how long has it been since you’ve shopped for insurance, both liability and health? Given the relentless upward trend of health insurance and the seemingly endless changes in the healthcare system, our recommendation is that you annually price your business’s health-insurance policies (and compare those prices with other polices out there).
We’re not suggesting that price should be your only consideration or that after you’ve found a lower price you should automatically wave good-bye to your current supplier. Rather, we’re suggesting that you be aware of the going rate in the marketplace and, where appropriate, either change suppliers or press your current supplier to reassess the prices it’s charging you. Squeaky wheels get the grease, and the effective control of expenses is no exception to this rule.
The preceding tips are a few of the many possible ways for you to control your business’s expenses. Remember that effective expense control isn’t a one-time event; it’s an ongoing occurrence whose success or failure lies entirely in your hands. Read the rest of this book for more smart business ideas that are cost effective.
2. Increasing margins
As we’ve mentioned, margin is the difference between sales price and the cost of the goods or services sold. (Gross margin is the accounting term you see on the balance sheet to mean the same thing.) Here’s a simple illustration of how to understand what the margin is on a given transaction: If your product sells for $15 and the cost of that product (including shipping charges) is $10, your margin is 33 percent — the $5 in markup divided by the $15 gross sales price. Your margin dollars are $5 (the difference between the $10 cost and the $15 sales price).
You can increase margins in three ways:
- By raising prices
- By lowering the cost of the goods or services sold
- By doing both
Regardless, the magic of increasing margins is that, similar to decreasing expenses, every dollar of income derived from the margin increase ends up as additional profit, assuming no reduction in sales.
Continuing with the preceding example, if you raise the price of the product from $15 to $16, the margin jumps from 33 percent to 37.5 percent, and the margin dollars increase from $5 to $6. Because increasing prices generally costs very little, nearly the entire $1 of the price increase will be realized as profit, again assuming no reduction in purchasing from customers.
Increasing margins by lowering the cost of goods or services sold is a little more difficult. If you’re a manufacturer, you must decrease the cost of manufacturing your product either by cutting your labor costs or by reducing the cost of the raw materials you purchase from vendors. If you’re a wholesaler or retailer, you must reduce the cost of the goods you purchase for resale. Similar to reducing prices, this method of increasing margins also results in a dollar-on-the-dollar recapture of profitability.
Consider the case of the small business that does $500,000 in sales in a year. If the owner, at the beginning of the year, decides to increase the prices of his products by an average of 1 percent, that would mean an additional $5,000 in profits at the end of the year. An average increase of 2 percent would add $10,000, and 5 percent would add a solid $25,000 (again, all this assumes that the price increases don’t reduce sales).
Generally speaking, small-business owners are more reluctant to raise prices than they should be. Too many times, your humble authors have witnessed reluctant small-business owners tremble in the course of reasonably raising prices, only to learn that their customers don’t care as long as the quality of the relationship endures. The tolerance of your customers to accept price increases depends on such issues as competition, alternative products, and, most of all, the customer relationships you maintain.
We strongly recommend that every small-business owner review the margins on every product or service at least once a year. Determine a time of the year when raising prices makes the most sense (usually at the beginning of the business’s fiscal year), mark that date on your calendar in ink, and when the time comes, start with your lowest-priced item and work up.
Analyze the percentage of price increase on each individual item. Don’t simply increase prices by using an across-the-board percentage increase. Also, be sure to aim for higher margins on the lower-priced items (those that aren’t as likely to be price-shopped by your customers) and on those products that don’t need to be as competitively priced.
But realize that you don’t have to wait until the end (or the beginning) of the year to consider increasing your prices. You may want to consider a price increase when the demand for your product suddenly increases.
Perhaps a competitor has raised its prices, or perhaps the law of supply and demand is hard at work — in other words, maybe more demand than supply for the product in question can provide a perfect scenario for raising prices. Don’t feel guilty for taking advantage of such situations — you’ll encounter plenty of occasions when the law of supply and demand works in reverse and you must cut your prices.
3. Increasing sales
After you have decreased (or controlled) your expenses and increased your margins, you can now focus on doing what every entrepreneur worth her weight in loan guarantees loves to do: increase sales.
After all, increasing sales is what most small-business owners are born to do, and besides, offense (increasing sales) is always more enjoyable than defense (cutting expenses). Everyone loves to roll out a new product, hire a new salesperson (it’s usually more fun to hire a salesperson than it is to hire a bookkeeper), or develop a new sales promotion. What’s more, you can easily measure the results of a plan to increase sales.
In most cases (the operative word here being most), the act of increasing sales adds profits to your bottom line, if those sales are priced at a high enough level to make them profitable. We stress the word most here because small-business owners too often attempt to solve their profitability problems by focusing only on increasing sales.
What they fail to realize is that if their sales aren’t made at a price high enough to generate a profit, then adding more sales will only serve to increase their cumulative losses. Or stated another way, sales alone don’t beget profitability; only profitable sales do.